Hilliard’s Weekend Notebook

Thoughts, views and opinions as current events unfold: With topics taken from current market events and my latest book — When the Bubble Bursts: Surviving the Canadian Real Estate Crash (Dundurn: March 2015) and my first book Investment Traps and How to Avoid Them (1999) — this short piece will give you unique and valuable insights filtered by my thirty-six years’ experience as an investment professional.

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OPEC - Are we at the start of a long bear market

According to a list in the Globe and Mail on December 23, 2014 Canada produces the equivalent of 3,948,000 barrels of oil per day. This production level puts Canada fifth in the world, just behind China in fourth place (4.1 million) and well below the Big Three —Saudi Arabia, the Russian Federation and the United States, all producing above 10,000,000 barrels.

The Globe also published an article on December 16 talking about the price of oil and Canada’s housing market by Don Pittis, “Face it, Canada’s housing market could fall like oil.” Pittis suggests that the most disturbing thing about the collapse in the price of crude oil, almost 50% in less than six months, is how few experts gave any warning. He also relates the severity of the collapse in WTI to the housing bubble and quotes me, but that’s a story for another day.

Commentators ignored oil production data which showed, for years, that the U.S. was growing production rapidly by exploiting “tight” or “shale” oil using new technology, including fracking. My clients will confirm that for more than a year we’ve been presenting, in our regular client meetings, a slide that highlights the exponential increase in U.S. production, from about 5 million barrels to 9 million barrels. In our model portfolio we’ve been underweight the energy sector since before 2008, although we still have one position -- about 4% weighting.

The only recent similar drop in oil prices was in 2008 when the financial crisis hit. It wasn’t too much oil that caused that drop but a global recession. Demand disappeared, the Saudis cut production and the price rebounded once the recession ended.

The last six months’ collapse in the oil price is different and more serious. This time the cause of the drop is a worldwide oil glut. The Saudis are tired of being the only one that sacrifices output for the good of the cartel. And the fact that two large producers, Russia and the U.S., are not members of OPEC and won’t cut production doesn’t help. Russia and the U.S. would be the big beneficiaries of a Saudi cut in production, not OPEC.

So OPEC, founded in Baghdad in 1967, has outlived its purpose and is defunct, in all probability. There are too many new producers in the world with large sources of production. Control of the world crude oil market is no longer possible. In history, cartels always have fallen apart; this one lasted much longer than most.

If OPEC is toast then what happens to energy markets and the price of oil? Well, a brief look at history will help. The price of crude oil peaked at $120 in 1979 after rising for ten years from a low of less than $10. From 1979 to 1998 the oil price dropped, a bear market lasting 19 years. Then the crude price shot higher, going from today’s dollar equivalent of about $20 to $140 in 2008. That bull market lasted about ten years, like the one that ended in 1979.

Now we are starting a new year, 2015, seven years into a bear market for crude oil. While most people I know here in Alberta talk about a rebound in prices, that’s not what history is saying. History suggests that we have at least another five to twelve more years of decline to come. Investment will slump, especially in higher cost production areas such as offshore drilling, shale and, dare I say it, oil sands. Lower cost producers will eventually regain control of the market and the new bull market will start again, but that point is several years into the future. A bear market lasting the equivalent number of years to the last one would end in 2027. This is what it looks like in a graph:

Source: The Motley Fool (www.fool.ca)

Alternative energy such as solar and wind are growing faster than most people realize. Widespread adoption of electric cars and trains would put a big hole in demand for crude. Tesla just announced an increase in the range of travel on one charge to 400 miles.

There hasn’t been any increase in petroleum product demand among OECD countries for five years now. Even China is showing very small increases, which surprises me, but the pollution problem is finally getting some attention from officials.

And millennials aren’t so enamored with car ownership and suburban living as the baby boomers. Some of the Y generation are opting to live closer to the centre of cities and don’t even own a car. If they need one they just rent.